This blog post written by Saanvi Singla, a student of University Institute of Legal Studies, Panjab University, provides an overview of the chit fund scheme and the laws that govern chit funds. 

Introduction

Everyone wants to save money. A method or a company that promises return on a person’s investment in a short span of time is not a new concept. Chit Fund is one such method. Chit fund is a saving scheme that is very popular amongst different types of people like homemakers, business person, etc. Chit Fund is the low-risk method through which you can save money.

What is a Chit Fund?

Chit fund is a saving scheme that is prevalent in India. A chit fund company is a corporation that governs, handles, or deals with such a chit fund, as defined in Section 2(b) of the Chit Funds Act, 1982. According to Section 2(b) of the Chit Fund Act, 1982:

“Chit means a transaction whether called chit, chit fund, chitty, kuree or by any other name by or under which a person enters into an agreement with a specified number of persons that every one of them shall subscribe a certain sum of money (or a certain quantity of grain instead) by way of periodical installments over a definite period and that each such subscriber shall, in his turn, as determined by lot or by auction or by tender or in such other manner as may be specified in the chit agreement, be entitled to the prize amount”.

Standardized financial institutions can conduct such schemes, or it can be in the form of unorganized schemes which are held between friends or relatives. In some kinds of chit funds, the savings are for a specific goal. Chit fund has proved to be useful throughout India, but the state of Kerala has benefitted from it the most.

In Kerala, chitty (chit fund) is a common practice done by all sections of the society. A company by the name of Kerala State Financial Enterprise exists under the State Government of Kerala, whose primary business activity is the chit. The concept of Chit fund came into the eyes of people in 1800’s when Raja Rama Varma, ruler of erstwhile Cochin state gave a loan to a Syrian Christian trader, by keeping a certain portion of it for himself for other expenses, and later he drew that money for the principle of equity.

How does a Chit Fund work?

Chit funds operate in different ways, and this can lead to many dishonest tactics that can be practiced by many private firms. The essential element of conducting a ‘Chit’ is a group of people called subscribers. The manager, i.e., the company or person conducting the chit fund — brings all the people together and conducts the chit. The manager is also responsible for the collection of money from subscribers, governing over the auctions, and keeping the records of the subscribers. He gets a fixed amount (generally 5% to 6% of the gross chit amount) monthly for his efforts for organizing the chit. Other than that, the manager has no distinct privileges; he is just a chitty subscriber and manager.

A simple formula depicts the pattern of the chitty:

Monthly Premium × Duration in Months = Gross Amount 

For example, Rs. 1000 * 50 = Rs. 50,000/-. (Where Rs. 1000 is the highest monthly contribution needed from a subscriber, 50 months is the duration the chit fund will last and Rs. 50,000 is the maximum sum guaranteed. The duration should be equal to the number of subscribers, as there must be (more or less) one subscriber to receive the prize money every month.)

The chit starts on a pre-decided date; every subscriber comes for the auction. As per the Kerala Chit Act, the minimum prize money of an auction is limited to 70% of the Gross Sum assured that would be Rs. 35,000 in the above-mentioned an example.

When there is more than one person who is willing to take the above mentioned minimum sum, lots are conducted, and the ‘Lucky Drawer’ gets the prize money for the respective month. If no person is willing to take the minimum sum, then a reverse auction will be conducted where subscribers open-bid for lower amounts; that is from 50,000 > 49,000 > 48,000, and so on. The person who bids the lowest amount will get the bid amount.

In both the cases the auction discount, i.e., the difference between the gross sum and auction amount, will be equally distributed among the subscribers or it is deducted from their monthly premium. For example, if the auction is settled on a sum of Rs. 40,000, then the auction discount of Rs. 10,000 (50,000 – 40,000) is divided by 50 (the total number of subscribers), and everyone will get a discount of Rs. 200. The same practice is repeated every month, and every subscriber has a fair chance of receiving some amount of money.

Due to this reason chit funds are considered as microfinance organizations.

Types of Chit Funds

There are various kinds of chit funds. Some of the major ones include:

• Organized Chit Funds: In North India, a common type of chit fund is where small paper slips with each members name are gathered in a box. When all the members come together for a monthly or a weekly meeting, the one who is in charge—in front of all the present members—picks a paper slip from the box. The member so selected gets that day’s whole collection. Afterward, that person’s name slip is removed from the box. After that, the previously selected person comes to the meetings and pays his/her share, but his/her name will not be selected again.
• Special Purpose Funds: Some chit funds are organized as a saving scheme for a much-specified purpose. For example, the Diwali sweets fund, which has a very specific end date which is about a week before Diwali. Neighborhood ladies all pool their savings each week. They use this collected sum to buy and prepare sweets in bulk just before the Diwali festival, and they distribute the sweets amongst all the members. Preparation of Diwali sweets can be a time consuming and costly affair for individuals. Such a chit can reduce the cost and relieves the members from extra work in the busy festival season. Nowadays, such special purpose chit funds are conducted by jewelers, kitchenware shops, etc. to promote their goods.
• Online Chit Funds: With the arrival of e-commerce in India, Chit funds are being organized online as well. Online chit funds organize auctions online, and subscribers can pay their monthly contributions and receive the prize money through online transactions including electronic funds transfer system. Each member gets an online account to manage and circulate chit funds.

Risk Involved with Chit Funds

Every kind of investment has its risks. The same rule applies to chit fund.  Some of the major issues are as follows:

• The biggest risk involving a chit fund is the misuse of the pooled funds by the manager. This can lead to a Ponzi scam.
• The other type of risk is when members stop paying the dues and have already taken the first bid.
• The third type of risk is when the discount rate is rigged, and a desperate member ends up paying a higher discount.

Due to these issues, it is advised to invest in a registered chit fund scheme. The Ministry of Corporate Affairs has a very exhaustive list of registered chit funds. Considering the above-stated risks, it is advisable to invest in chit funds very carefully.

Laws that Govern Chit Funds

Chit funds in India are governed by various State or Central laws. Organized chit fund schemes are required to be registered with a Registrar or Firms, Societies, and Chits. The chit funds are governed according to the following laws:

• Union Government – Chit Funds Act, 1982 (Except the State of Jammu and Kashmir)
• Tamil Nadu Chit Funds Act, 1961
• The Chit Funds (Karnataka) Rules, 1983
• Delhi Chit Funds Rules, 2007
• Maharashtra Chit Fund Act, 1975
• West Bengal Protection of Interest of Depositors in Financial Establishments Bill, 2013
• Prize Chits and Money Circulation Schemes (Banning) Act, 1978

The Reserve Bank of India (RBI) is the regulator of banks and other non-banking financial companies, but it does not control the chit fund business. Despite the fact that chit funds accept deposits, the term ‘deposit’ as defined by the Reserve Bank of India Act, 1934 does not comprise the subscription to chits. However, the RBI can always guide State Governments on the regulatory aspects of the creation of rules or exemption of certain chit funds. The latest guidelines provided by the RBI regarding the Chit are given in RBI/2014-15/636.

As the regulator and controller of the securities market, SEBI regulates and manages collective investment schemes.  But the SEBI Act, 1992 specifically precludes chit funds from their definition of collective investment schemes.[1]

Prevention of Money Laundering (Amendment) Act, 2012 has recognized Chit Funds in Section 2(l).

Under Prize Chits and Money Circulation Scheme (Banning) Act, 1978 (PCMCS) ‘Conventional Chit, ‘ i.e., the chit mentioned above has been defined in Section 2(a). In this act, another type of chit has also been defined under Section 2(e) named as ‘Prize Chit’ and it is banned in the territory of India. Prize chit is different from conventional chit as prize chit involves the sale of certificates, units, and other instruments and there is an admission fee also, whereas, conventional chit does not contain any of those features.

Conclusion

Chit Fund is a good way to save money. It is short term in nature, and the amount is not exorbitant. It can be organized in a very informal manner and can be designed according to one’s needs. Despite all these reasons one has to be careful about the kind of chit fund on is participating and with whom. After the Saradha Group financial scandal, the Supreme Court has passed many guidelines on the governance of the Chit Funds.

Reference:

[1] http://www.prsindia.org/theprsblog/?p=2678